Oil: Vollatility Happens But Collateral Damage Kills You

The US Energy Information Administration’s latest Short-Term Energy Outlook , forecasts that Organization of the Petroleum Exporting Countries (OPEC) member countries not counting Iran will experience oil export revenue 14% lower at year-end 2014 compared to a year ago. That is $700 billion left in the pockets of oil consumers over the last year.

If you are a filling your gas tank you are cheering. But this is the worst OPEC performance since 2010 not just because oil prices declined but because demand for oil was down and OPEC just sold less of it. The forecast from US EIA does not get better for 2015 with its estimate that oil prices will average only $68 over the next year. OPEC members will lose another $446 billion.

As if this pain is not enough, low oil prices also cause collateral damage to both OPEC members and other nations trapped in the volatility of the market. Here are examples of collateral damage at work:

• Iran is excluded from EIA calculations because its oil exports are sanctioned and thus must be done off the books using discounts, exchanges or other manipulation to avoid official financial channels where if it is caught the assets can be seized. For Iran doing such deals not only means suffering the falling price of the market it means getting stung by the discounts or kickbacks it must pay to make it worth the risk to the buyer. No one feels sorry for Iran.
• OPEC countries like Venezuela, Iraq, Ecuador, Libya, Algeria, Nigeria, Gabon and Angola are heavily dependent on oil export revenue and thus are facing serious collateral damage from income shortfalls from lower prices. Their financial interests are very different from Saudi Arabia and the Gulf states in OPEC but they lack the clout to change the outcome of a decision to hold production levels up knowing prices will fall. These OPEC members see few benefits.
• Non-OPEC Russia faces the potential collapse of its currency from the combined impacts of lower oil and gas prices and international sanctions imposed because of its seizure of Crimea and menacing threats to take Eastern Ukraine in President Putin’s goal for a buffer from the West.
• The oil and gas industry faces major geopolitical risk premiums as lower oil prices wreak havoc with new projects, capital investment and complex business deals now unraveling.

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So how long with this last?

After the November 27th OPEC meeting where Saudi Arabia said it would hold production at the current level of 30 billion barrels per day the spin on the story was the cause was that oil demand had fallen below supply levels. What we soon learned was that actual OPEC supply levels were even high—600,000 barrels a day higher meaning the OPEC members were in ‘business as usual’ mode—they cheated! Next we heard that Saudi Arabia decided to hold production steady because it did not want to lose market share to the United States from growing oil production.

The official story from OPEC is that we should get used to low oil prices because they will be around for a long time. That view coincided with U.S. EIA’s December 12th drilling report that US crude oil production is projected to average 9.3 million b/d in 2015, up 700,000 from 2014 but 200,000 less than projected. Moreover, the biggest producing basins, Bakken, Eagle Ford, Niobrara and Permian Basin, are expected to continue drilling in part due to hedges that provide coverage for falling prices down to about $87 per barrel.

Other producers began to cut back on drilling plans for 2015 and new drilling permits were down in the last month in North Dakota suggesting the impact of low oil prices is still rippling through the market. Goldman (NYSE:GS) piled on with a forecast released November 27th the same day at the OPEC meeting projecting that WTI would average $70 to $75 per barrel and Brent, will average $80 to $85 in London. It said it expected rig rates to fall by 20%. January 15th futures contracts for WTI fell to $55 and Brent to $59.

Collateral damage, the ugly twin sister of volatility seemed to be doing a good job of spreading the pain. The market reaction then seemed to look for the food fight ahead. Was Saudi Arabia taking on the US shale revolution and imposing lower prices to break the back of US production growth? Is this a game of OPEC chicken with the US?

While the geopolitical intrigue at work certainly includes the US-Saudi relationship, but the answer of why this and why now is more complicated.

• World economic growth is sluggish and some countries are slipping back into recession. China’s economy is slowing and that panics its many suppliers. The ripple effect of slower growth in China is compounded by even worse economic performance in Europe. The rest of the BRICS once seen as the engine of global growth for the future are sputtering. It is a time of growing uncertainty and fears seem to amplify the implications of volatility.
• Flight to quality and safety. The home for both is widely seen as the United States. The US stock market is one of the few bright spots for growth as evidenced by the volatile but generally higher stock prices, earnings reports and sense that the US is finally turning the corner and getting back to growth. As democrats in the US Congress and the White House lament ‘income inequality’ the rest of the world’s investors are asking “can I get in on that?”Stocks are up one day and down the next in sometimes heart pounding rides. But interests rates are very low and there is no place else for commodity investors to go but the stock markets even if there are a scary ride some days.
• Oil market volatility reflects the search for equilibrium from the imbalance of supply and demand that is driving oil prices lower is part of the same flight to safety and quality. Saudi Arabia and the Gulf States sit on huge reserves and equally huge sovereign wealth funds they can tolerate volatility and even provoke it from time to time when their national interests require it.

For much of OPEC and the non-OPEC oil producing nations, low oil prices are a disaster. Holding OPEC production levels at a higher level than market demand may be a deliberate strategy by Saudi Arabia to discipline the cheaters among OPEC members from taking its market share. It may be designed to force a change in the negotiations between Iran and the US and EU over Iran’s nuclear program if the Saudi’s fear that Team Obama is about to give away the store to the mullahs leaving Saudi Arabia vulnerable. We will know soon, but if it turns out the real reason for the Saudi action is any of these factors it will be an enormous price to pay for pique!

Saudi Arabia may be demonstrating that OPEC still matters. Why? Because it knows it cannot stop the US shale revolution. The Americans are going to overtake the Saudi’s as the largest oil producer in the world. America’s proved reserves are growing and don’t yet count the hard to get at resources. America is earning the clout to become the world’s swing oil producer and thus the arbiter of price. The Saudi’s may slow it and frustrate it but they cannot stop it. And nothing will ever be the same after that happens.

Written By: Gary Hunt